HEDGE FUND PRIMER FOR INVESTMENT ADVISERS

Transcription

1 HEDGE FUND PRIMER FOR INVESTMENT ADVISERS Charles H. Field Chapin Fitzgerald LLP June 1, Charles H. Field

2 HEDGE FUND PRIMER FOR INVESTMENT ADVISERS CONTENTS INTRODUCTION 1 TYPES OF FUNDS 2 Traditional Private Fund 2 Private Equity/Venture Capital Funds 2 Hybrid Funds 2 Fund of Funds 3 STRUCTURING THE FUND 4 Limited Partnerships and Limited Liability Companies 4 The Master-Feeder Fund Structure 5 MARKETING THE FUND TO CLAIM AN EXEMPTION FROM INVESTMENT COMPANY REGISTRATION: SECTIONS 3(c)(1) and 3(c)(7) 7 3(c)(1) Fund 7 Section 3(c)(7) 9 MARKETING THE FUND TO CLAIM THE EXEMPTION FROM SECURITIES REGISTRATION: REGULATION D 9 Rule 501: Accredited Investors 10 Rule 502: Limitation on the Manner of Offering 10 Rule 506(b): The Traditional Private Placement of Fund Interests 11 Rule 506(c): JOBS Act Rule Permitting General Advertising 11 Rule 506(d): The Bad Actor Disqualification 12 Form D Notices 14 Rule 508: Non-Compliance 14 BROKER-DEALER ISSUES 14 Use of Finders and Broker-Dealers 14 COMMODITY INVESTMENT: WHAT IT MEANS FOR INVESTMENT ADVISERS AND PRIVATE FUNDS 16 Commodity Interests: The Investment Portfolio 17 The Commodity Pool: The Fund 17 The Commodity Pool Operator (CPO): The Entity that Sponsors the Fund 18

3 The Commodity Trading Advisor (CTA): The Investment Adviser to the Fund 18 The Associated Person (AP) 18 Registration Requirements 19 EXEMPTIONS FROM REGISTRATION 19 Exemption for CPOs: Rule 4.13(a)(3) 19 Exemptions for CTAs: Section 4m 20 Exemption for CTAs: Rule Registration Lite: Rule Claiming the Exemptions 21 FIDUCIARY ISSUES: OPERATING THE FUND 21 Disclosure Obligations 22 Due Diligence 23 Performance Fees 24 Side Letters 24 Side-By-Side Management 26 Side Pockets 27 Side Pocket Policies to Consider 29 FUND OPERATIONAL ISSUES 29 Custody 29 Lock-Up Periods 30 Holdbacks 30 Gates 30 Unrelated Business Income Tax 31 Form PF Reporting Obligations 31 Avoiding Publicly Traded Partnership Status 32 ERISA ISSUES 33 ERISA EXEMPTIONS 34 Venture Capital Operating Company 34 Real Estate Operating Company 34 Alternative Investment Fund Manager Directive (AIFMD) 35 CONCLUSION 36 ABBREVIATIONS, ACRONYMS, and INITIALISMS 37

4 HEDGE FUND PRIMER FOR INVESTMENT ADVISERS Charles H. Field INTRODUCTION There is no universally accepted definition of a hedge fund, either legal or industry-wide. Some funds pursue very aggressive investment practices, such as borrowing and speculating in commodities. Others resemble single-strategy mutual funds and very often do not hedge their portfolios against market movements or pursue leverage. The funds might be pools of illiquid assets whose gains will take years to realize, if at all. Given the different variations on the investment theme, it is much more useful to understand a hedge fund as synonymous with a private fund: a fund that is not registered as an investment company with the US Securities and Exchange Commission. The investment policies and strategies of the fund can be as constrained or as unconstrained as the portfolio manager desires. But structurally speaking, hedge funds generally have the following characteristics: They consist of a pool of assets from multiple investors meeting the legal requirements for investing in an unregistered fund; They are organized as a limited partnership or limited liability company; They are less expensive to operate than mutual funds that are constrained by regulation; They require a high minimum investment; They generally impose a performance fee on investment gains; Marketing of the fund is either prohibited or highly restricted; and Investor access to their capital is restricted, in some cases up to two years or more. There are a multitude of other features that are market and regulatory driven, based on the type of investor the investment adviser seeks to attract. Investment advisers catering to the institutional market will structure their funds to appeal to a more sophisticated investor, while those catering to an individual investor market will structure something entirely different. Tax-exempt investors may require a structure that is wholly inappropriate for taxable investors. Operating a private fund involves, at a minimum, the Securities Act of 1933, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Blue Sky Laws of the states where the investment adviser attracts investors, and a host of federal tax regulations. It could also involve the Securities Exchange Act of 1934 and the Commodity Exchange Act, not to mention the Employee Retirement Income Security Act of 1974 and the European Alternative Investment Fund Managers Directive. Operating a private fund is a complex business, and issues appear from all different directions.. It is our hope that this Primer will assist you in identifying the various private fund issues and formulating a plan of action that will lead to an efficiently managed fund that generates outstanding returns for investors. 1

5 TYPES OF FUNDS Section 3(a)(1)(A) of the Investment Company Act of 1940 (Investment Company Act) defines an investment company as any issuer that is or holds itself out as being engaged primarily in the business of investing, reinvesting, or trading in securities. A private fund whose purpose is to trade in anything that is a security (e.g., stocks, bonds, notes, options, warrants, and other securities derivatives), whether publicly traded or privately held, will fit the definition of an investment company. Traditional Private Fund Traditional private funds are designed to generate returns by trading both long and short in the securities of publicly traded operating companies across the globe, with micro, small, mid, and large capitalizations. Other private funds may focus on particular industries or sectors, while yet others are designed to produce alpha by managing market volatility though various well-defined hedging mechanisms, such as the VIX and other index futures. The funds are free to borrow money to purchase securities and, in fact, do so to leverage the gains of the portfolio. While many of these traditional private funds are focused primarily on a narrow strategy, other private funds have a less defined investment strategy that authorizes the portfolio manager to exercise broad investment discretion over the portfolio and invest in whatever the manager believes will generate the best return. The liquid nature of the portfolio allows traditional private funds to offer quarterly, even monthly, liquidity to its shareholders. Private Equity/Venture Capital Funds Other private funds will trade primarily in illiquid securities, including private equity and debt. The funds even may be designed to provide venture capital to start-up entities. In either case, these types of funds pursue a much longer-term strategy and restrict shareholders ability to redeem their investments. The private equity or debt fund may invest in Private Investments in Public Equity (PIPEs) or distressed debt. A venture capital fund invests primarily in start-ups and may take a role in the management of the company. The venture capital fund is defined generally as one that invests in a venture capital strategy, limits its borrowings to 15% on a relative short-term basis, and does not provide shareholders with redemption rights except in extraordinary circumstances. The investment adviser to a venture capital fund is exempt from the registration requirements under the Investment Advisers Act of 1940 (Investment Advisers Act) and the fund itself is exempt from the Employee Retirement Income Security Act (ERISA), as discussed later. Hybrid Funds It is not uncommon to see a fund that invests in both liquid and illiquid securities. These hybrid 2

6 funds are appealing to investment advisers and investors alike. Investment advisers can maintain a partially liquid portfolio while pursuing more attractive, lesser-known opportunities in privately held companies. Shareholders are drawn to these funds for the same reasons. Despite their appeal, hybrid funds pose significant legal, operational, and marketing challenges for investment advisers relative to valuing illiquid assets, calculating the performance fees on illiquid assets, and maintaining liquidity in a falling market for investors seeking to redeem. When the capital markets seized up in 2008, many hybrid funds were either not able or not willing to honor substantial redemption requests, because their portfolios had become illiquid. As a result, shareholders gained awareness of fund features such as lock-ups, gates, suspensions, and side pockets, as investment advisers took defensive measures to protect their funds from collapse. In the cases of the traditional fund, the private equity/venture capital fund, and the hybrid fund, an investment adviser monitors individual holdings and makes investment decisions on individual securities. Aside from the securities held in the portfolio, the major difference among these funds is the ability of the investors to liquidate their investments for cash. Funds that invest in liquid securities tend to be open-end funds whose interests are continuously offered, and they tend to provide monthly or quarterly redemption rights for investors. Private equity and venture capital funds, on the other hand, are generally of the closed-end variety, raising a set amount up front, making capital calls on investors as investments are made along the way, and distributing the profits as they are realized. Fund of Funds Another type of private fund is the fund of funds. Unlike a direct fund, where a portfolio manager makes individual investment decisions, a fund of funds is a portfolio constructed by a portfolio manager of interests issued by a number of other private funds. The fund can focus on a particular investment strategy, such as investing in publicly traded stocks or private equity, or allocate among many different strategies. Investment selections are based primarily on the skill, reputation, and expertise of the underlying investment adviser. The advantage of a fund of funds is that an investment adviser can add value by judiciously selecting and monitoring other investment advisers. In addition, the fund of funds allows investors with limited funds to gain access to more private fund investment advisers over which to diversify their assets. For example, an investor with $250,000 can be efficiently exposed to a number of private fund advisers instead of only one. One of the disadvantages is the layering of expenses the expenses of the fund of funds and the expenses of the underlying funds. The doubling of fees can have a significant adverse impact on the total return an investor receives. Another disadvantage is the lack of transparency into the underlying funds. Whether a fund is a direct fund, a fund of funds, a fund that invests in liquid securities, a fund that invests in private equity and start-ups, or a fund that invests in a variety of investments, the investment adviser of each type of fund will look to structure the fund and attract investors based on a variety of 3

7 factors, including the types of investors they will seek, the types of investments they will make, and the amount of resources they can commit to operating the fund. STRUCTURING THE FUND Limited Partnerships and Limited Liability Companies The proper construction of a fund should ensure limited liability of the investor and efficient tax treatment for both the fund and its shareholders. A fund organized as a corporation accomplishes the first goal, but it is tax inefficient. For example, investment profits earned by the corporation are subject to federal income tax when earned, and again when distributed to investors, thereby subjecting the investment profits to double taxation. To avoid this drag on performance, investment advisers to private funds organize their funds primarily as either limited partnerships or limited liability companies, which afford flow-through tax treatment to investment gains and losses, and provide limitations on the liability of investors. Funds organized as limited partnerships and limited liability companies do not themselves pay tax. Instead, the profits and losses attributable to a fund s investments flow through to investors in proportion to their investment in the fund. Each investor will be required to report on its Federal income tax return its distributive share of the fund s income or gain, whether or not it receives any actual distribution of money or property from the fund during the taxable year. The uniform limited partnership and uniform limited liability company acts adopted in one form or another by the various states provide that the debts, obligations, and liabilities of these funds, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the fund and not of the investors. In Delaware, for example, under of the Revised Uniform Partnership Act, an investor is not obligated personally for any such debt, obligation, or liability of the fund solely by reason of being an investor. Investors do share the investment losses, but only to the extent of their respective interests in the fund. Limited partnerships and limited companies are generally organized by filing with the secretary of state either a certificate of limited partnership or a certificate of formation. Limited partnerships and limited liability companies are governed by the limited partnership agreement on the one hand and the operating agreement on the other. Responsibility for the overall management of the fund will rest with the General Partner for limited partnerships and with the Managing Member for limited liability companies. The agreement generally will name the investment adviser or an affiliate as the general partner or managing member, as the case may be, and grant the investment adviser a great deal of flexibility and authority to manage the fund without interference from investors or other third parties, such as a board of directors or a trustee. These agreements will also provide the investment adviser with the strongest indemnification possible. They may provide for lock-up periods, holdbacks, redemption in-kinds, and limit the investors rights to transfer their interests. 4

8 The Master-Feeder Fund Structure Investment advisers may seek to offer an investment strategy that appeals to a wide range of investors, such as high net worth individuals, non-us investors, institutions, and tax-exempt investors. Certain restrictions, however, present a host of challenges to organizing a fund that has broad appeal. For example, a domestic fund organized as a limited partnership or limited liability company that utilizes borrowing (also known as acquisition indebtedness) as an investment strategy may be unattractive to taxexempt investors. This is because earnings generated from borrowing would flow through to the investors and possibly subject the tax-exempt investors to unrelated business income tax. The same fund also may be unattractive to non-us investors, given that the tax rules require the fund to withhold tax at the source on the profits of investors who do not have a tax identification number. A domestic fund would also put the non-us investor under the jurisdiction of the Internal Revenue Service. An offshore fund would likely be the more attractive option to US tax-exempt and non-us investors because (a) the fund would be organized in a tax haven jurisdiction and not subject to local tax, and (b) the unrelated business income from an offshore company would not receive flow-through tax treatment. While the offshore fund would be attractive to tax-exempt US investors, it would be equally unattractive to taxable US investors because of the unfavorable tax rules governing passive foreign investment companies (PFICs). To deal with these diversified needs, the investment adviser may consider either organizing two separate side-by-side funds or creating a master-feeder fund structure. Under the master-feeder structure, the investment adviser establishes a master fund that holds and invests the assets. Various feeder funds are then organized in one or more jurisdictions to feed their assets into the master fund for investment in a single strategy. Each feeder fund is designed to accept contributions from different groups of investors based on certain criteria driven primarily by tax status and place of domicile. In the case of a fund that employs leverage, an offshore fund would be organized to accept tax-exempt and non-us investors. This is because, unlike the profits of a limited partnership and a limited liability company, the profits earned by an offshore company are recognized at the company level and do not flow through to the investor. Accordingly, margin-financed profits do not flow through to the investors, thus eliminating the issue of unrelated business income tax. In addition, the profits of an offshore fund that invests in a non-us portfolio are not subject to US withholding tax, and thus for non-us investors the offshore fund has a competitive advantage over domestic funds. A domestic fund would be organized to accept US taxable investors seeking to avoid PFIC issues. The assets of both feeder funds are combined into one master fund and invested according to a single investment strategy. Each feeder fund is its own separate legal entity with its own fee structure for investment advisory fees, performance fees, sales charges, and operating expenses. 5

9 In Chart 1, the investment adviser has established two side-by-side funds, and hence two separate investment portfolios: one domiciled in the Cayman Islands and one domiciled in Delaware. For investment advisers, side-by-side funds present some issues, with performance dispersion being at the top of the list. Many advisers seeking the efficiencies of managing one portfolio instead of two find the masterfeeder fund structure appealing. In Chart 2, the investment adviser establishes a master fund in the Cayman Islands. Two feeder funds are also created: one in Delaware, the other in the Cayman Islands. Contributions from tax-exempt investors come into the master fund by way of the Cayman Islands feeder fund, and contributions from US taxable investors come into the master fund by way of the Delaware L.P. While the portfolio efficiencies of the master-feeder structure may look appealing to investment advisers, it is much more complex and expensive to operate. Instead of creating and operating two funds, the investment adviser creates, operates, and pays for three. Absent sufficient assets that will generate economies of scale, the expense of the master-feeder structure could offset any portfolio efficiencies. Another consideration when evaluating the master-feeder structure is that its investment strategies may not offer advantages to all investors at all times. For example, long-term capital gains treatment may be preferred by US taxable investors, but taxes are not a concern for tax-exempt investors, so if the master fund holds a security longer to receive favorable tax treatment, it may create conflicts of interest among the different groups of investors. 6

10 Finally, there may be integration issues that could inadvertently lead to two funds being treated as one, triggering fund registration under the Investment Company Act. While the master-feeder fund structure has its place, careful consideration must be given before plunging headlong into its complexities. MARKETING THE FUND TO CLAIM AN EXEMPTION FROM INVESTMENT COMPANY REGISTRATION: SECTIONS 3(c)(1) and 3(c)(7) Section 7(a) of the Investment Company Act prohibits an investment company from operating unless it is registered pursuant to Section 8 or is excluded from registration. Registering a fund with the US Securities and Exchange Commission (SEC) is a complicated and expensive process. Operating a registered fund requires continuous compliance with a byzantine array of complex rules and regulations. This includes the fund providing pricing and liquidity daily; empaneling a board of directors and holding regular meetings; filing reports annually and semi-annually; updating prospectuses annually; and, through the board, reviewing and approving the investment advisory agreement annually. These annual fund operating expenses could run into the hundreds of thousands of dollars and, unless they are picked up by the fund s investment adviser, adversely affect the performance of the fund. Because of the time, expense, and distraction associated with a registered fund, many investment advisers that lack the business interest or the distribution resources to enter the retail fund space opt for the private fund option. Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities. This definition would apply to anything from the billiondollar mutual fund with tens of thousands of shareholders to the smallest weekly investment club whose members debate the merits of an odd-lot investment over coffee. Fortunately for the investment club and other start-up funds, section 3(c) of the Investment Company Act of 1940 specifically excludes certain entities from the definition of an investment company, and thus from the complicated registration process. The two most commonly used provisions are sections 3(c)(1) and 3(c)(7). 3(c)(1) Fund Section 3(c)(1) of the Investment Company Act excludes funds whose number of shareholders is no more than 100 and whose capital raising does not involve a public offering. But there are certain traps for the unwary when calculating the number of investors. One trap lies in the look-through provisions. Generally, an entity that invests in a fund will be counted as one shareholder unless that investor entity is itself an investment fund, the investor entity owns 10% or more of the outstanding voting securities of the fund, and the aggregate amount of the investor entity s investment in the fund represents 10% or more of the investor entity s total assets. In that instance, the investor entity s ownership in the fund will be attributed to every owner of the investor entity. 7

11 For example, in the case of a $10 million fund with four investors, Investor A, which is organized as a limited partnership with 99 partners and $10 million of its own in assets, and whose primary purpose is investing, invests $2 million in another fund managed by an unaffiliated investment adviser. For purposes of counting the number of shareholders in the fund, section 3(c)(1) and rule 3c-1 thereunder require the fund to look through the limited partnership and include in the count all 99 partners = 102; and accordingly, under this scenario, the fund will fail to qualify for exclusion under section 3(c)(1). To avoid this trap, the investment adviser must be diligent in adopting and adhering to a policy of not accepting investments from any entity whose investment would exceed 10% of the fund. Since no start-up entrepreneur desires to turn money away, another approach is to conduct due diligence on the entity, which the investment adviser can and generally does accomplish through a questionnaire and other investor representations and warranties contained in the fund s Subscription Agreement. The second trap lies in the concept of integration, or treating two or more like funds as one, and counting the aggregate number of investors in the funds to determine whether they exceed 100. For example, an investment adviser launches a second global macro fund after the number of investors in the first fund reaches 100. Under certain circumstances, the SEC would treat both funds as one 3(c)(1) fund, so that at the time the number of investors in both funds combined exceeded 100, neither fund would qualify for the Section 3(c)(1) exemption. There is no statute that addresses fund integration, and the SEC has not adopted any formal rules that outline what may trigger integration. Guidance on integration, however, can be found in a number of no-action letters, which lay out the following tests: Are the different offerings a part of a single plan of financing? Do the offerings involve issuance of the same class of security? Are the offerings made at or about the same time? Is the same type of consideration to be received? Are the offerings made for the same general purpose? Would an interest in one fund be considered materially different from an interest in a second partnership by a reasonable investor qualified to purchase both? Do the funds have the same investment objectives; the same types of portfolio securities; and, particularly, similar portfolio risk return characteristics? In Oppenheimer Arbitrage Partners LP (avail. Dec. 26, 1985), the SEC did not integrate two funds where one fund was offered to tax-exempt investors and did not engage in short sales or write uncovered calls, while the other fund was offered to taxable investors and engaged in short sales and other leveraged transactions. In Shoreline Fund (avail. Apr. 11, 1994), the SEC did not integrate an offshore fund with an onshore fund, both with almost identical investment strategies, on the grounds that the offshore fund was created for non-us and US tax-exempt investors, while the onshore fund was created for taxable investors. Conversely, in Frontier Capital Management Company (avail. May 6, 1988), the SEC refused to grant no-action relief to three funds where one invested in a portfolio of large cap stocks, the other in a 8

12 portfolio of small cap stocks, and the third in a balanced portfolio of stocks and bonds. The SEC noted that the three funds were designed for one group of investors with similar investment profiles. Therefore, it appears that to avoid integration, the investment adviser should design the fund for different groups of investors: institutional, individual, taxable, or non-taxable. Another consideration in counting the number of shareholders is Rule 3c-5, which allows the fund to exclude from the count any person who at the time of purchase is a knowledgeable employee of the investment adviser and any company owned exclusively by such knowledgeable employees. Rule 3c-5 generally defines a knowledgeable employee to include certain executive officers of the fund or the investment adviser; heads of business units who perform a policy-making function; and non-executive employees who, in connection with their regular duties or functions, participate in the investment activities of a fund managed by the investment adviser. Traders, salespersons, staff lawyers, operations and information technology staff, and junior analysts who do not regularly participate in the stock selection process do not fit within the definition. In cases where a knowledgeable employee jointly owns the fund with his or her spouse, the joint account would not count toward the fund s 100-owner limit (see American Bar Association Section of Business Law no-action letter [avail. April 22, 1999]). Finally, Rule 3c-6 protects the fund from involuntary transfers accidentally triggering the 100- beneficial-ownership test. The rule provides that beneficial ownership of a transferee who acquired the interests by way of gift, bequest, or dissolution of marriage is deemed beneficially owned by the transferor for purposes of counting the number of shareholders. The second requirement is that the offering must be private. Provided the investment adviser markets interests in the fund consistent with the requirements of Regulation D (as more fully explained in the next section), then the offering will be considered private. Accordingly, careful adherence to Rule 506 of Regulation D is critically important, including a set of offering materials that include all appropriate disclosure legends and restrictions on transfers required by Regulation D. Section 3(c)(7) Section 3(c)(7) excludes funds that are owned exclusively by qualified purchasers and whose capital raising does not involve a public offering. A qualified purchaser is generally an individual or a family-owned entity that owns at least $5 million in investments, or an institution that owns and invests at least $25 million, or a knowledgeable employee. Identical to the Section 3(c)(1) prohibition on public offerings, the 3(c)(7) offering must be private and consistent with the requirements of Regulation D, as more fully explained in the next section. MARKETING THE FUND TO CLAIM THE EXEMPTION FROM SECURITIES REGISTRATION: REGULATION D The role of raising assets is crucial to a fund s success. The investment adviser needs adequate assets to invest and diversify so it can generate fees and cover expenses. Investment advisers know all too well the tough competitive challenges in raising assets, but there are legal challenges as well. 9

13 Section 5 of the Securities Act of 1933 (Securities Act) makes it unlawful to offer or sell a security unless the issuer has filed its prospectus with the SEC and the SEC has deemed it effective. Registration under the Securities Act is a complicated and expensive process, requiring, in most cases, extensive negotiations with the SEC staff over disclosure issues. Because of the time, expense, and distraction associated with registering securities and updating the registration annually, investment advisers of funds tend to seek an exemption from registration. Section 4(2) of the Securities Act exempts transactions that do not involve a public offering from the registration process. Nowhere in the statute is public offering defined. To bring clarity to this matter, the SEC adopted Regulation D, and related Rules , in which it established safe harbor provisions. Compliance with these provisions will conclusively bring the fund within the Section 4(2) exemption. A discussion of exemptions in Rules follows. Rule 501: Accredited Investors Investment advisers to private funds that seek to rely on the safe harbor provisions of Regulation D will require, with few exceptions, that all of the fund s investors meet the definition of an accredited investor. This includes banks, pensions, insurance companies, and individuals whose net worth exceeds $1,000,000, or whose individual income exceeds $200,000 or joint income exceeds $300,000. In addition, all offerees who purchase must possess the requisite level of sophistication that allows them to evaluate the merits and the risk of the investment. Although Rule 506(b) under Regulation D permits up to 35 non-accredited investors and an unlimited number of accredited investors, most private funds will limit its investors to accredited investors, due in large part to the requirement that non-accredited investors must receive two years of additional financial and other information similar to what would be furnished in a registration statement. Rule 502: Limitation on the Manner of Offering Unless the investment adviser intends to sell interests in the fund solely to accredited investors pursuant to Rule 506(c) (as discussed below), Rule 502(c) prohibits the fund and the investment adviser from using any form of general solicitation or general advertising in the capital raising process. While there is no definition of general solicitation or general advertising" in the statute, Regulation D broadly defines this to include advertisements, articles, notices, and other communications published in newspapers, magazines, and the internet, as well as general invitations to participate in promotional seminars and meetings. For investment advisers, the issue will most likely arise when dealing with client newsletters, client seminars, blasts to clients, and investment adviser web sites. By far the most difficult and pervasive questions concerning Rule 502(c) under Regulation D have concerned the determination of what will be deemed a general solicitation." The SEC has tended to focus on whether the investment adviser has a preexisting substantive relationship with the investor. 10

14 In H.B. Shaine & Co. (avail. May 1, 1987), a broker-dealer proposed using questionnaires to identify investors who would be accredited under Rule 501(a)(1). The broker-dealer would update the questionnaires annually, and the questionnaires would serve as the basis for an established list of accredited investors. The firm then intended to offer private placements to the persons on the list. In agreeing that the questionnaires provided sufficient detail to establish a substantive relationship, the SEC stated that a satisfactory response by a prospective offeree to a questionnaire that provides a brokerdealer with sufficient information to evaluate the respondent s sophistication and financial situation will establish a substantive relationship. Because this relationship would be established prior to any offering, the staff also agreed that the relationship was preexisting. In Lamp Technologies, Inc. No-Action Letter (avail. May 29, 1997, divisions/investment/noaction/1997/lamptechnologies pdf; follow-up letter, May 1998), the SEC issued guidance on how private funds could post information about themselves on a web site operated by a third party and still comply with the prohibition on general solicitation and advertising under Regulation D and the prohibition on a public offering in sections 3(c)(1) and 3(c)(7). Lamp proposed to establish and administer a web site that contained information concerning privately offered, exempt funds. An interested investor could gain access to the information within the password-protected site only after (1) he or she had completed a questionnaire designed to allow Lamp to form a reasonable basis for determining that the investor was an accredited investor, and (2) Lamp had issued the investor a password to access the site. To prevent an investor from joining the service and immediately investing in a particular fund, Lamp set a 30-day cooling-off period before an investor could invest. By using a questionnaire that provided Lamp with sufficiently detailed information to evaluate the potential investor s sophistication, requiring the use of a password, and imposing a 30-day cooling-off period, Lamp was able to establish a substantive relationship with a potential investor. Rule 506(b): The Traditional Private Placement of Fund Interests Rule 506(b) exempts the fund from registering its securities regardless of the size of the offering. To qualify for the exemption, the securities may only be offered and sold to accredited investors, as defined in Rule 501, and up to 35 non-accredited investors. As a practical matter, however, most investment advisers to private funds will not want to accept non-accredited investors into the fund, except under the most limited circumstances, because of Rule 505(b). This rule requires that the fund must provide non-accredited investors with the same information that it would provide in a securities registration statement. Under Rule 506(b), the issuer may not engage in general solicitation or general advertising of the offer, as defined in Rule 502, and the issuer must have a reasonable belief that the purchasers are accredited investors or sophisticated, non-accredited investors. Rule 506(c): JOBS Act Rule Permitting General Advertising As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd- Frank), provisions under Rule 506(c) have given investment advisers of private funds more latitude in how they market and promote their fund. Effective September 23, 2013, the final Jumpstart Our Business 11

15 Startups Act (JOBS Act) rules removed the 80-year-old ban under Rule 502 on general solicitation and advertising, under certain conditions. Advisers of private funds now may promote funds through public web sites and other forms of social media, provided that each investor in the fund meets the Rule 501 definition of an accredited investor and the investment adviser has taken reasonable steps to verify that the investors in fact meet the definition. Accordingly, Rule 506(c) necessitates that investment advisers adopt policies and procedures reasonably designed to ensure that each investor in the fund is an accredited investor. Rule 506(c) requires investment advisers to take reasonable steps to verify that the investors in the fund are accredited investors, which is a higher standard than Rule 506(b) s reasonable belief standard. In a Rule 506(b) offering, investment advisers generally rely on investor representations made in the subscription agreement, without independently verifying the financial status of the investor. But if the fund uses Rule 506(c) to promote its interests, the SEC will expect the adviser to exercise greater diligence than before in ascertaining accredited investor status. The SEC has indicated the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. In other words, the principles-based method allows the investment adviser to follow the rule of reason in determining whether an investor is or is not accredited. For example, the risk of noncompliance is very low in the case of an investor who invests $1 million or more into the fund. The adopting release lists several nonexclusive and nonmandatory methods that it considers reasonable steps to verify accredited investor status. These include: a. For income verification: Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040; b. For net worth verification: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and for liabilities, a consumer report from at least one of the nationwide consumer reporting agencies; and c. Independent verification from (1) a registered broker-dealer, (2) an investment adviser registered with the SEC, (3) a licensed attorney who is in good standing under the laws of the Jurisdictions in which he or she is admitted to practice law, or (4) a certified public accountant who is duly registered and in good standing. Given that investment advisers may be reluctant to assume this reasonable step burden, investment advisers increasingly may look to third parties (e.g., lawyers, accountants, and established angel investor groups) to review and verify the investor information, in order to certify the accuracy and legal qualification for which the third party must bear responsibility. Rule 506(d): The Bad Actor Disqualification As another consequence of Dodd-Frank, the SEC has adopted Rule 506(d) under the Securities Act to disqualify certain bad actors from relying on the exemption from registration in Rule 506. As a result, companies are now prohibited from relying on Regulation D in connection with a private offering 12

16 pursuant to Rule 506 if certain persons related to the fund participate in bad acts on or after September 23, Investment advisers will need to collect this information in the form of a questionnaire from all persons and entities connected to the fund, to ensure compliance with these new requirements. These persons and entities will include the Issuer (the company issuing the securities); any predecessor to the Issuer; any affiliated companies; beneficial owners of 20% or more the Issuer s outstanding voting equity, calculated on the basis of voting power; promoters under Rule 405 who are currently connected to the Issuer in any capacity; investment advisers of the funds; broker-dealers and solicitors of the fund; and, as applicable, directors, executive officers, and other officers of any of the above. Membership in any of these categories is to be determined at the time of sale; thus, additional people might need to complete the questionnaire as the offering progresses if the membership of any of the above categories changes. Investment advisers must conclude a person will fit the definition of a bad actor if they affirmatively answer any question in the questionnaire related to the following after September 23, 2013: a. Certain criminal convictions for felonies or misdemeanors and certain court injunctions in connection with certain securities activities and making false statements to the SEC; b. Final orders of certain state and federal regulators of securities, commodities, insurance, banking, savings associations, or credit unions constituting a bar from engaging in certain activities; or final orders based upon fraudulent, manipulative, or deceptive conduct; c. Certain SEC disciplinary orders, cease and desist orders, and stop orders; d. Suspension or expulsion from membership in a self-regulatory organization (SRO), such as the Financial Industry Regulatory Authority (FINRA), or from association with an SRO member; or e. US Postal Service false representation orders. Even though September 23, 2013 was the trigger date, bad actor disqualifying events that existed before that date are required to be disclosed in writing to investors. Issuers must furnish this written description to purchasers within a reasonable time before the Rule 506 sale. Even though disqualification will not arise as a result of disqualifying events that occurred before September 23, 2013, Rule 506 is unavailable to a fund that fails to provide the required disclosure, unless the issuer is able to demonstrate that it did not know, and, in the exercise of reasonable care, could not have known that a disqualifying event was required to be disclosed. Failure to qualify for exemption under Rule 506(b), (c), and (d) can have serious consequences. Given that advisers potentially face strict liability under the Securities Act Section 12(a)(1) for selling unregistered securities that otherwise should have been registered, advisers must exercise great care in designing a program and the proper forms that demonstrate they have taken reasonable steps to comply with Rule 506(b), (c), and (d). 13

17 Form D Notices Form D is a form the fund files to perfect its exemption under Rule 504, 505, or 506 of Regulation D. SEC rules further require the notice to be filed online within 15 days after the first sale of securities in an offering. For this purpose, the date of first sale is the date on which the first investor is irrevocably contractually committed to invest. The SEC does not charge any filing fee for a Form D notice or amendment. If the fund is continuing to offer its interests, it will need to file an amendment annually, on or before the first anniversary of the most recent previously filed notice. Many states also require the filing of Form D notices and amendments, and most of them charge a filing fee. For information on state Form D filing requirements, visit to get links to the proper state web sites. State web sites contain bulletins providing details on filing requirements and a contact person for specific questions. At the present time, all states that require Form D filings accept paper filings only; none permit online filings. Rule 508: Non-Compliance Rule 508 offers a defense to a fund that has failed to comply in all respects with Rules 506. The defense cannot be raised in an SEC enforcement action. To avail itself of the defense, the fund must show three things: (1) the provision with which it failed to comply was not intended to protect the investor who seeks rescission, (2) the failure to comply was not significant, and (3) the fund made a good faith effort to comply. So for example, a fund may raise a 508 defense if it fails to file a Form D, or if it fails to give investors an opportunity to ask questions. There are two activities that will always be significant and therefore excluded from the 508 defense: (1) general solicitation (except Rule 506[c] offerings), and (2) the numerical purchaser limit. BROKER-DEALER ISSUES Use of Finders and Broker-Dealers Investment advisers may choose among several options to distribute interests in their private funds to investors. They can utilize external groups such as broker-dealers, finders, and internet sites. They can also utilize an internal sales force, or hope to rely on word of mouth. In 2013, the SEC began focusing its attention on this area through no-action letters, an enforcement action, and speeches. The SEC has distinguished those activities that it would consider finder activities and those it would consider broker-dealer activities that require a broker-dealer license. In doing so, the SEC has called into question the long-standing practice of investment advisers using internal salespersons as agents of the fund and relying on the issuer exemption from broker-dealer registration. Investment advisers who are not careful in this area are vulnerable to a regulatory enforcement action and, even worse, rescission claims by investors. 14

18 Section 3(4) of the Securities Exchange Act defines a broker as any person engaged in the business of effecting transactions in securities for the account of others. Believing that the presence of a transaction-based success fee, or the so-called salesman s stake, can lead to high-pressure tactics, the SEC places heavy emphasis on transaction-based fees when evaluating whether a person is in the brokerdealer business. Section 15(a)(1) of the Securities Exchange Act makes it unlawful for any broker or dealer to effect any transaction in the purchase or sale of any security unless the broker or dealer is registered pursuant to Section 15(b). For the person who should have been registered but isn t, then every investor who has purchased from such unregistered person may rescind the purchase pursuant to Section 29(b) of the Act. As the SEC enforcement action against Ranieri Partners ( 2013/ pdf) exemplifies, investment advisers can be subject to SEC enforcement action under Section 20(e) of the Securities Exchange Act for assisting non-registered third parties in soliciting sales of fund shares without a broker-dealer license. Ranieri Partners illustrates that the SEC will pursue investment advisers who turn a blind eye to third parties who solicit potential investors for the investment adviser s funds. In this particular case, Ranieri Partners hired an unregistered individual to introduce investors to the investment adviser and its funds in exchange for a 1% finder s fee. However, the business relationship evolved into something more. Ranieri furnished the individual with private placement memoranda (PPMs), subscription documents, and marketing materials. The individual then furnished them to prospective investors. Ranieri knew or should have known that the individual actively met with potential investors to discuss the fund s investment strategy, investment performance, and asset allocation. It is not surprising that the SEC found that the individual had engaged in unregistered, and thus illegal, brokerdealer activities; however, it was surprising to see the SEC pursue Ranieri on an aiding and abetting charge, as well. Although Ranieri involved an external third party, the same issue can arise for investment advisers that use an internal sales force to market their fund. In the past, investment advisers tended to rely on the issuer exemption under Rule 3a4 1 promulgated under the Securities Exchange Act (17 CFR Part 240.3a4 1) to avoid registering as a broker-dealer, claiming that the fund was the issuer selling for its own account, and not the account of others, and their employees were associated persons carrying out that function. Rule 3a4 1 is a non-exclusive safe harbor. Rule 3a4 1 provides that an associated person (or employee) of an issuer who participates in the sale of the issuer s securities would not have to register as a broker-dealer if that person, at the time of participation: (1) is not subject to a statutory disqualification, as defined in Section 3(a)(39) of the Act; (2) is not compensated by payment of commissions or other remuneration based directly or indirectly on securities transactions; (3) is not an associated person of a broker or dealer; and (4) limits its sales activities as set forth in the rule. However, the SEC has suggested that a narrow reading of Rule 3a4 1 raises broker-dealer compliance issues for the activities of internal sales staff paid on commission. 15

19 Following up on the Ranieri Partners case, David Blass, the Chief Counsel of the SEC Division of Markets and Trading, gave a speech before the American Bar Association s Trading and Markets Subcommittee. He put investment advisers on notice that their internal sales activities may involve broker-dealer activities as a result of the methods of compensating their sales personnel and, in the case of private equity fund managers, the receipt of investment banking fees with respect to their portfolio companies (April 13, 2013, In evaluating whether the internal sales efforts of an investment adviser give rise to broker-dealer activity and registration as a broker-dealer, the investment adviser should analyze the following: How does the adviser solicit and retain investors? Do employees who solicit investors have other responsibilities? How are personnel who solicit investors for a private fund compensated? Do those individuals receive bonuses or other types of compensation that are linked to successful investments? A critical element to determining whether one is required to register as a broker-dealer is the existence of transaction-based compensation. This implies that bonuses tied to capital raising success would likely give rise to a requirement for the individuals receiving such bonuses to register as brokerdealers. In the Funders Club No-Action Letter (avail. Mar. 26, 2013, marketreg/mr-noaction/2013/funders-club a1.pdf), and Angel List LLC No-Action Letter (avail. Mar. 28, 2013, the SEC granted no-action relief to investment advisers that operated an internet-based platform exclusively for accredited investors. When the investment advisers identified prospects in which to invest, it posted investment information on the web site that could only be accessed by members who were accredited investors and who may or may not reply with an indication of interest. Once indications of interest reached certain levels, the investment adviser would close the transactions with the prospects. Investors paid administrative fees to defray actual out-of-pocket expenses; the investment manager received a performance fee based on the profits of the fund. Key factors in the decision to grant relief were: (a) the Investment advisers received compensation for their advisory service and not transaction-based compensation; (b) employees of the investment adviser did not receive transaction-based compensation; and (c) none of the administrative fees were paid to the investment adviser for selling activities. COMMODITY INVESTMENT: WHAT IT MEANS FOR INVESTMENT ADVISERS AND PRIVATE FUNDS Historically, the Commodity Exchange Act (CEA) had limited application to investment advisers and sponsors of private funds because of the sophisticated investor exemption. Funds that traded in 16